After years of thrashing around proposals, securities regulators are now going to require investment funds to adopt an oversight mechanism. Fund firms will have until next spring to set up committees to oversee potential conflicts of interest between fund managers and their products.

The struggle to require fund managers to adopt a minimum governance structure has been ongoing since the Ontario Securities Commission ordered a report on the subject in 2000, which was written by Stephen Erlichman, senior partner at Fasken Martineau DuMoulin LLP in Toronto. Five years earlier, the lack of independent oversight was pointed out by then-commissioner Glorianne Stromberg in her seminal report examining the fund industry.

Despite the long-standing recognition that the funds industry lacks mandatory governance, the effort to introduce it has proven contentious. Some in the industry argue that mandatory governance is not necessary and will be too costly. A rarely heard-from faction — retail investors — insist some sort of governance requirement is essential. (See comments on page 46.)

For a change, investors, their advocates and governance champions such as the International Organization of Securities Com-missions got their way on the issue. Acknowledging cost concerns in its final rule proposal, the Canadian Securities Administrators says the cost is trumped by its fears that the conflicts of interest faced by fund managers “may present a real challenge to their ability to meet their fiduciary duty to their funds and investors.” The CSA notes that, until now, there has been no one with the sole responsibility for defending investors’ interests.

That responsibility will now fall to the independent review committees (IRCs) that fund firms must set up to oversee all decisions that may present conflicts of interest. The rule is concerned with both “business/operational” conflicts and “structural” conflicts, such as prohibited transactions. The CSA notes the potential for conflicts is exacerbated because related parties often provide services to funds without any independent review.

By requiring an independent check, regulators say, the new rule will improve investor protection, increase transparency around fund managers’ resolution of conflicts and enhance market efficiency by allowing funds to engage in certain related-party and self-dealing transactions without getting prior approval. For example, bank-owned fund managers have had to get regulatory permission to enable their portfolio managers to buy their parent banks’ stock for their funds. This represented a significant obstacle in the Canadian market, in which the big banks represent a large portion of business.

Although various CSA members have agreed to adopt the fund governance rule, the debate about whether it represents an appropriate balance between added investor protection and market efficiency isn’t entirely settled.

The CSA’s position is that its rule “strikes the right balance between protecting investors and fostering fair and efficient capital markets” and brings the Canadian industry up to global governance standards. Yet, investor advocates maintain that attempting to balance industry and investor interests is misguided, and cost-sensitive skeptics insist the rule is unnecessary.

“We believe striking a balance between investor protection and what is good for the industry, as has been done in the past, does not provide adequate protection for small investors,” says Stan Buell, president of the Markham, Ont.-based Small Investor Protection Association. “As long as regulators are more con-cerned about creating optics to convince investors all is well rather than taking action that protects investors and provides an efficient means of restitution for victims of industry wrongdoing, seniors and widows will continue to be at risk of losing their savings.”

Buell argues such efforts are fruitless without greater enforcement. “It’s about time government realizes the current regulatory regime does not protect investors and takes action to introduce an authority not controlled by the industry to represent the consumer/investor interests,” he says.

Investor advocates aren’t the only skeptics. The B.C. Securities Commission expresses reservations about the endeavour, saying the costs may not be justified by the benefits. It issued a notice of its own along with the CSA notice, indicating it plans to offer an exemption from the rule for fund firms that operate solely in British Columbia. There are only five fund management firms that operate just in B.C., and all five manage venture-capital funds that have corporate boards of directors at the fund level. Firms that want to do business outside B.C. will have to comply with the new rule.

@page_break@The rule is still subject to government approvals before it becomes official. Assuming approvals are granted, the requirement will take effect Nov. 1. From that date, investment funds — including mutual funds, exchange-traded funds, closed-end funds and scholarship plans — will have six months to set up IRCs.

The new obligation will probably be a formidable challenge for some fund managers, particularly smaller ones. Some larger firms have had IRCs or similar bodies for some time, partly to take advantage of exemptions allowing them to carry out otherwise prohibited transactions. For those that have to start IRCs solely to comply with the new rule, there will be added costs.

From the outset, cost has been a persistent concern for the fund governance initiative. The OSC produced a cost/benefit analysis of its 2002 governance proposal, which estimated that version of the rule would impose $17.9 million in initial set-up costs and $65.9 million in ongoing annual costs for the industry.

The analysis, however, was criticized for understating the costs and failing to account for expenses such as recruiting, training and insuring IRC members, along with the added burden on management time and liability concerns. A further cost analysis, released in 2004, focused primarily on the benefits, which accrue mainly to larger fund firms.

In the recent notice accompanying the final rule, the CSA says it continued to receive criticism about the potential costs of its proposals for small fund managers. It has concluded, however, that conflicts also exist at small funds, and they should be required to have a minimum level of governance to deal with the in–stances: “We continue to believe there are inherent conflicts of interest in the management of smaller investment funds that will benefit from the independent perspective brought to bear on such matters by an IRC.”

Regarding liability, the CSA has re-ceived a legal opinion suggesting IRC members’ liability would be less than that of ordinary corporate directors. It notes corporate directors have overall responsibility for managing the corporation, whereas IRC members would have to scrutinize specific issues. Also, the CSA says, although IRC members will probably have a fiduciary duty to the fund, they won’t owe one to individual unitholders.

Although that opinion may ease potential IRC members’ concerns, it will still be a chore for some firms to assemble the committees. Fund industry analyst Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. , worries less about costs falling disproportionately on smaller firms — costs, he notes, that will be paid by the funds — and more about the challenge small firms face in finding qualified people for their committees.

Moreover, he laments the general increase in the regulatory burden fund managers are facing. At least one small manager recently wound up his top-performing fund, citing overall increasing regulatory demands — although not specifically the governance rule.

Hallett says the trend toward greater regulation may discourage smaller shops from offering prospectus-sold funds: “Many gems are found in smaller operations, in part because of their modest size. It’s a shame, but it’s part of being in an even more heavily regulated environment.”

The creeping costs aren’t likely to stop. The CSA expects the fund governance regime will evolve over time, and the IRC rule isn’t the end of the road.

The original Erlichman report recommended numerous governance reforms. Some, such as mandatory adoption of compliance plans, may yet come to fruition, as suggested in the OSC’s latest statement of priorities and outlined in a statement published by Erlichman on his firm’s Web site (www.fasken.com).

The CSA’s registration reform project also proposes that fund managers be required to register in a newly created category, a move that would shift the registration obligation from fund issuers to managers. Such a change would give regulators the ability to keep “unsuitable individuals” from acting as fund managers and ensure that managers have adequate resources and minimize conflicts.

Beyond governance issues, fund managers will have to contend with other regulatory changes, including tighter rules on use of “soft” dollars. The CSA is proposing a rule that would clearly define what qualifies for the use of soft dollars and sets out new disclosure requirements.

In general, the CSA proposal notes that soft dollars can only be used for order execution and research services, and it reiterates that they must be used for the benefit of clients. It also mandates disclosure of soft-dollar practices. IE